One of the most difficult and important decisions you’ll make as an entrepreneur is determining which methodology to follow when pricing your products or services.
Price setting is a crucial step in the long-term strategy of all businesses. While there is no singular, "correct" way to determine your price, this article will break down some guidelines to help you make an informed decision based upon the goals of your business.
Positioning Your Pricing Strategy
Consider how you’re planning to position your product in the market: Is pricing going to be a key part of your sales pitch? If you're running a discount store, you’ll likely be striving to keep your prices as low as possible (or at least lower than your competitors) as a way to draw new customers in.
On the other hand, if you're positioning your product as part of a luxury brand, a price that's too low may hurt the sense of exclusivity you’re trying to achieve. In either case, the pricing has to be consistent with your positioning in the marketplace.
Effects on Demand
Ask yourself: How will pricing affect demand? You're going to have to do some basic market research to find out. Get 10 people to answer a simple questionnaire, asking, "Would you buy this product/service at X price? Y price? Z price?"
For a larger venture, you might want to consider a more structured approach, such as hiring a market research firm. This exercise should not become a surrogate for your own understanding of the data; the market research professionals can help your business conduct a more detailed test, but you’re the one responsible for studying the relationship between the results and pricing strategy.
Calculate the fixed and variable costs associated with your product or service. Determine your cost of goods (a cost associated with each item sold or service delivered) as well as your fixed overhead (a set of costs that do not vary, like rent or insurance).
Remember, your gross margin (price minus cost of goods) has to amply cover your fixed overhead in order for you to turn a profit. When entrepreneurs underestimate the importance of these basic calculations, they may choose a pricing methodology ill-suited to the value they’re offering customers.
Are there any legal or regulatory constraints on pricing? For example, in some cities, towing fees from auto accidents are set at a fixed price by law. Similarly, for doctors, insurance companies and Medicare will only reimburse a certain price.
What actions might your competitors take in response to your pricing decisions? Will your unusually low price trigger a price war?
Research the external factors that may affect your pricing strategy and begin considering your businesses pricing objectives by asking yourself, “What am I trying to accomplish with my pricing?”
Short-Term Profit Maximization
Making as much profit as possible, as quickly as possible, sounds great, but it may not be the optimal approach for long-term profits. This strategy is risky. Short-term profit maximization is common in companies that are bootstrapping, as cash flow is the overriding priority. This strategy is common among smaller companies hoping to attract outside investment by demonstrating their profitability in a short amount of time. If a business increases prices to maximize profits in the short term, it might encourage more comparators to enter the market.
Short-Term Revenue Maximization
This approach seeks to maximize long-term profits by increasing market share and lowering costs through economies of scale. For a well-funded company or a newly public company, revenues are considered more important than profits in building investor confidence.
Higher revenues at a slim profit, or even a loss, show that the company is building market share and will likely reach profitability. Amazon.com, for example, posted record-breaking revenues for several years before ever showing a profit. Amazon's market capitalization reflects the high investor confidence those revenues generated, and this pricing methodology accurately reflects its overarching mission to become the largest online retailer.
This pricing methodology might be used by a company that's well-funded by founders and investors in order to maximize market penetration (think penetration pricing). There are a few reasons to choose this pricing strategy, in particular, as a way to focus on reducing long-term costs through achieving economies of scale.
This strategy is particularly appropriate when you expect to have a lot of repeat customers or when the long-term plan is to increase profits by reducing costs and upselling existing customers on higher-profit products.
Maximize Profit Margin
This pricing strategy makes sense when the number of sales is either expected to be low, sporadic, and/or unpredictable. Examples include custom jewelry, art, hand-made automobiles, and other luxury items.
At one extreme, being the low-cost leader is a form of differentiation from the competition; at the other, a high price is meant to signal high quality and/or a high level of service. Some people really do order lobster just because it's the most expensive thing on the menu, so, for a very few, differentiation can be a viable pricing strategy.
In response to a price war, market decline, or the saturation of a certain market, you must temporarily pursue a pricing strategy that will cover costs and allow you to continue operation.
As mentioned earlier, there is no single methodology for every business when calculating the price. Once you've considered the various factors involved, and determined the objectives of your pricing strategy, you will need to crunch the actual numbers.
Here are four methodologies to calculate your pricing:
To figure your cost-plus pricing, set the price at your production cost, including both cost of goods and fixed costs at your current volume, plus a certain profit margin. For example, your widgets cost $20 in raw materials and production costs, and, at your current sales volume (or anticipated sales volume), your fixed costs come to $30 per unit. Your total cost is $50 per unit. You decide that you want to operate at a 20% markup, so you add $10 (20% x $50) to the cost and come up with a price of $60 per unit. So long as you have your costs calculated correctly and have accurately predicted your sales volume, you will always be operating at a profit.
Target Return Pricing
Set your price to achieve a target return-on-investment (ROI). Using the same situation as above, let's assume that you have $10,000 invested in the company, and your expected sales volume is 1,000 units in the first year. You want to recoup all your investment in the first year, so you need to make $10,000 profit on 1,000 units, or $10 profit per unit, giving you a price of $60 per unit.
Price your product based on the value it creates for the customer. The most extreme variation on this is "pay-for-performance" pricing for services, in which you charge on a variable scale according to the results you achieve. Let's say that your widget above saves the typical customer $1,000 a year in energy costs. In this case, $60 seems like a bargain—maybe even too good a deal. Customers would pay hundreds of dollars more if your product could reliably produce this level of cost savings.
Ultimately, you must take into consideration the consumer's perception of your price, factoring in things like:
- Positioning: If you want to be the "low-cost leader," you must be priced lower than your competition; if you want to signal high quality, you should probably be priced higher than most of your competition.
- Popular price points: There are certain price points, or specific prices, at which people become much more willing to buy a certain type of product. For example, a price under $100 is a popular price point at which to target a product. A price totaling under $20 (including sales tax) is a popular price point, as is food for under $1, the basis for many fast-food '"value menus." Dropping your price to a popular amount might mean a lower margin, but more than enough increase in sales to offset it.
- Fair pricing: There is simply a limit to what consumers perceive as "fair" pricing. If it's obvious that your product only costs $20 to manufacture, even if it delivered $10,000 in value, you'd have a hard time charging $2,000 to $3,000 for it. A little market testing will help you determine the maximum price consumers will perceive as fair.
So, how do you combine all of these calculations to come up with a pricing methodology that works for your business?
- Your price must be higher than what it costs you to cover reasonable variations in sales volume. If your sales forecast is inaccurate, how far off can you be and still be profitable? Ideally, you want to be able to be inaccurate by a factor of two or more (your sales are half of your forecast) and still be profitable.
- You have to make a living. Have you figured a salary for yourself into your costs? If not, your profit has to be high enough for you to earn a living wage, while having money left over to reinvest in the company.
- Your price should almost never be lower than your costs or higher than what most consumers consider fair. This may seem obvious, but many entrepreneurs seem to miss this simple concept, either by miscalculating costs or by inadequate market research to determine fair pricing. If people won't readily pay enough for you to make a fair profit, you need to reconsider your business model entirely. How can you cut your costs substantially? Or change your product positioning to justify higher pricing?
Pricing is a tricky and fundamental part of doing business. You're certainly entitled to make a profit on your product—even a substantial one if you create value for your customers—but remember that a product or service is only worth what the consumer is willing to pay for it.